I was looking at a recent case wondering: why did this
even get to court?
Let’s talk about life insurance.
The tax consequences of life insurance are mostly straightforward:
(1) Receiving
life insurance proceeds (that is, someone dies) is generally not an
income-taxable event.
(2) Permanent
insurance accumulates reserves (that is, cash value) inside the policy. The
accumulation is generally not an income-taxable event.
(3) Borrowing
against the cash value of a (permanent) insurance policy is generally not an
income-taxable event.
Did you notice the word “generally?” This is tax, and
almost everything has an exception, if not also an exception to the exception.
Let’s talk about an exception having to do with
permanent life insurance.
Let’s time travel back to 1980. Believe it or not, the
prime interest rate reached 21.5% late that year. It was one of the issues that
brought Ronald Reagan into the White House.
Some clever people at life insurance companies thought
they found a way to leverage those rates to help them market insurance:
(1) Peg the accumulation of cash value to that
interest rate somehow.
(2) Hyperdrive the buildup of cash value by
overfunding the policy, meaning that one pays in more than needed to cover the
actual life insurance risk. The excess would spill over into cash value, which of
course would earn that crazy interest rate.
(3) Remind customers that they could borrow
against the cash value. Money makes money, and they could borrow that money
tax-free. Sweet.
(4) Educate customers that – if one were to die with
loans against the policy – there generally would be no income tax consequence.
There may be a smaller insurance check (because the insurance is diverted to
pay off the loan), but the customer had the use of the cash while alive. All in
all, not a bad result – except for the dying thing, of course.
You know who also reads these ads?
The IRS.
And Congress.
Neither were amused by this. The insurance whiz kids were
using insurance to mimic a tax shelter.
Congress introduced “modified endowment contracts”
into the tax Code. The acronym is pronounced “meck.”
The definition of a MEC can be confusing, so let’s try
an example:
(1) You are age 48 and in good health.
(2) You buy $4,000,000 of permanent life
insurance.
(3) You anticipate working seven more years.
(4) You ask the insurance company what your annual
premiums would be to pay off the policy over your seven-year window.
(5) The company gives you that number.
(6) You put more than that into the policy over
the first seven years.
I used seven years intentionally, as a MEC has something
called a “7 pay test.” Congress did not want insurance to morph into an
investment, which one could do by stuffing extra dollars into the policy. To combat
that, Congress introduced a mathematical hurdle, and the number seven is baked
into that hurdle.
If you have a MEC, then the following bad things
happen:
(1) Any
distributions or loans on the policy will be immediately taxable to the extent
of accumulated earnings in the policy.
(2) That
taxable amount will also be subject to a 10% penalty if one is younger than age
59 ½.
Congress is not saying you cannot MEC. What it is
saying is that you will have to pay income tax when you take monies (distribution,
loan, whatever) out of that MEC.
Let’s get back to normal, vanilla life insurance.
Let’s talk about Robert Doggart.
Doggart had two life insurance contracts with
Prudential Insurance. He took out loans against the two policies, using their cash
value as collateral.
Yep. Happens every day.
In 2017 he stopped paying premiums.
This might work if the earnings on the cash value can
cover the premiums, at least for a while. Most of the time that does not happen,
and the policy soon burns out.
Doggart’s policies burned out.
But there was a tax problem. Doggart had borrowed
against the policies. The insurance company now had loans with no collateral,
and those loans were uncollectible.
You know there is a 1099 form for this.
Doggart did not report these 1099s in his 2017 income.
The IRS easily caught this via computer matching.
Doggart argued that he did not have income. He had not
received any cash, for example.
The Court reminded him that he received cash when he
took out the loans.
Doggart then argued that income – if income there be -
should have been reported in the year he took out the loans.
The Court reminded him that loans are not considered
income, as one is obligated to repay. Good thing, too, as any other answer would
immediately shut down the mortgage industry.
The Court found that Doggart had income.
The outcome was never in doubt.
But why did Doggart allow the policies to lapse in
2017?
Because Doggart was in prison.
Our case this time was Doggart v Commissioner,
T.C. Summary Opinion 2023-25.
